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A B2B Exchange for ... Oil

THE (FILL-IN-THE-BLANK) SECTOR in Japan is a Byzantine network of trading companies, brokers, distributors, and retailers working under a closed, cozy, and collusive system in which prices aren't transparent, relationships aren't visible, and deals are generally kept secret, with the result that price-busting outsiders remain firmly in the minority. Need a hint? The answer, of course, is almost any market segment. But a particularly good answer would be "oil."

Tetsuya Wada learned early in his career just how closed and insular most oil trading in Japan is, with the majority of deals closing in bilateral secrecy between some 8,000-odd trading companies and distributors. Inflated prices are passed down the line to the final buyer (which include some 3,000 gas stations and a host of large industrial users, like the Tokyo Electric Power Company), and the industry as a whole suffers from massive over-regulation.

All of this dawned on Wada in the late '80s, when he worked for Japan Energy, one the nation's top five petroleum refiners and producers. In the mid-'90s, MITI decided to partially deregulate the industry, with one of its reports coming to the startling conclusion that -- gasp! -- one-to-one trading was bad for pricing.

Initial efforts, however, have had little effect, and the industry as a whole runs at a $5 billion loss each year, says Wada.

At the start of 1999, Wada took an early retirement package from Japan Energy and decided to use the money, about two years' salary, to seed his own startup. That May he founded EC-Com, and shortly thereafter applied for a "system patent" (read: business model patent).

EC-Oil's electronic escrow marketplace started booking transaction revenues just four months after the site's launch in August last year. EC-Oil provides a bid-based, trusted-third-party system where buyers and sellers can negotiate bulk oil purchases in complete anonymity -- important for establishing true market-made prices. The system essentially follows the stock market model, with sellers setting minimum prices and buyers bidding on oil lots. EC-Oil only deals with JIS (Japan Industrial Standards)-approved oils, so all parties can be certain of commodity quality.

EC-Oil now has 90 companies -- including two of the large trading houses -- registered on the market, and Wada's target is to boost that number as fast as possible. "It's a challenge to get companies to join, but our system makes use of several features that MITI recommended, so we have good support from the bureaucrats," he says.

EC-Oil makes its money from a tariff on each trade (¥0.2 per litre), and, down the road, Wada plans to open a futures market.

Participants in the EC-Oil exchange can view lot information via the Web, including lot number, type of oil, minimum ask price, minimum quantity, location of goods, payment method, and bidding period. Bids can be placed by email, fax, or by telephoning EC-Oil's call center, and the company has developed an i-mode-accessible site.

For now, EC-Oil.com is not offering true Web-based ecommerce (once a bid is accepted, the transaction is completed offline), since few companies in the oil industry have any interest in the Net. "Less than 20 percent of companies in Japan's oil industry use the Internet -- and those that do use it mostly for email and browsing," says Wada. "EC-Oil is not a pure Net venture -- we want to build a hybrid company that combines escrow services and an oil marketplace. It's a very different model."

The essence of EC-Oil's business is risk management, as the service accepts all risk associated with the buying and selling of oil, including the performance risk (is the commodity really what the seller claims?), the reputation risk (most participants wish to remain anonymous), and the credit risk (is payment guaranteed?). These factors have been one source of the industry's traditionally closed practices, as the primary aspect of the trading houses' and middleman dealers' business has been risk acceptance -- which generates tremendous pressure to coerce buyers and sellers into accepting artificial prices advantageous to no one but the trading houses themselves.

But the trading companies' massive size and dominance of the markets makes them ill suited to react quickly to a change agent like the Net. "Some companies -- for example, Marubeni -- know the real meaning of the commodity trading business. However, most of the shoshas (trading companies) do not and cannot change their style of business so quickly," says Dr. Seiichi Shin, associate professor at the University of Tokyo's School of Engineering, who has studied Internet-based methods of distribution.

But oil in particular is a ticklish area. For one thing, it's strategically important for Japan, which has none of its own, and in the past there's been a lot of pressure on the government to play an active role in regulating the industry. Some historians argue that the threat of an oil embargo helped propel Japan into the Pacific War. Such pressure seems to be diminishing today. "Oil is still significant in Japan," says Shin, "but we are now preparing for a big paradigm shift from oil to natural gas. Therefore, the importance of oil is now declining. True competition among oil, coal, natural gas, and nuclear power will lead to a revitalization of Japan's industry."

Daniel Fujii, managing director at Internet Capital Group's new Tokyo office, says, "Shoshas are big players, but they do not control everything. Electronic markets can survive in Japan."

But whether EC-Oil is at the front of a revitalization of Japan's energy industries is a question that only time -- and investors -- can answer.

Given the fact that a few large companies now dominate the top of the food chain, some investors may be wary of putting any money into an oil-trading startup. "While I imagine there will be a need for EC-Oil's services, particularly if the industry has numerous layers of intermediaries, I think that it's going to be a long battle uphill, and ultimately they'll have to either specialize in a small niche of services based on the Internet, or they will have to partner-up with some of the big guys," says Bruno Grandsard, principal at boutique VC Japan Internet Ventures. Nonetheless, Grandsard remains bullish on electronic marketplaces like EC-Oil: "As an investor, I would definitely look at such a plan, but would treat it quite cautiously." Academic Shin also thinks caution is warranted, adding: "There are few people working in this field who know the real meaning of ecommerce. It needs a tight understanding of the right direction of IT."

Meanwhile, some investors aren't waiting -- a consortium of 11 Japanese VCs provided Wada with his first cash infusion in October. He approached foreign VCs, but found their requirements too narrow. "There were too many conditions," he shrugs. "They wanted to place two directors on my board -- even after the IPO." Speaking of which, the firm is eyeing an IPO in the third quarter of next year, and Wada is looking for a subsequent round of venture funding before then.

Post-IPO, the firm plans to establish commodity markets for cement, chemicals, and paper, among others. It's also looking into licensing its patent-pending system for use in other countries.

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